The Different Types of Financial Ratios
Introduction
Financial ratios are used to measure a business’s financial performance and health. They are calculated by comparing different numbers from a business’s financial reports such as balance sheets, income statements and cash flow statements. Financial ratios can be used to give a quick overview of a company and can provide investors with insight when making decisions.
There are several main categories of financial ratios. These include profitability ratios, liquidity ratios, asset turnover ratios, leverage ratios and valuation ratios. Below is an overview of the types of financial ratios and what they measure.
Profitability Ratios
Profitability ratios measure a company’s ability to generate profits from its operations.
- Gross profit margin: This measures a company’s cost control as it relates to its revenue
- Net profit margin: This measures the overall profitability of a business
- Operating expense ratio: This measures how much of its revenue a business is spending on operating expenses
Liquidity Ratios
Liquidity ratios measure a company’s ability to meet its short-term financial obligations.
- Current ratio: This measures a company’s short-term liquidity
- Quick ratio: This measures a company’s ability to quickly convert current assets into cash
- Cash ratio: This measures the percentage of a company’s current liabilities that can be paid off with its current assets
Asset Turnover Ratios
Asset turnover ratios measure the efficiency with which a company uses its assets.
- Total asset turnover ratio: This measures the total amount of assets that a company is using to generate sales
- Inventory turnover ratio: This measures the number of times a company is able to turn its inventory into sales
- Fixed asset turnover ratio: This measures the efficiency of a company’s long-term assets in generating sales
Leverage Ratios
Leverage ratios measure a company’s ability to service its long-term debt.
- Debt to equity ratio: This measures the relationship between a company’s debt and equity, and can be used to measure its financial risk
- Debt to asset ratio: This measures the total amount of a company’s debt compared to its assets
- Interest coverage ratio: This measures the ability of a company to meet its interest payments
Valuation Ratios
Valuation ratios measure the value of a company relative to others in the same industry.
- Price to earnings ratio: This measures a company’s current market price relative to its earnings
- Price to book value ratio: This measures a stock’s market price relative to its book value
- Price to sales ratio: This measures a company’s stock price relative to its sales
Liquidity Ratios
Liquidity ratios measure a company’s ability to pay off its short-term debt obligations with its current assets. These ratios provide insight into a company’s financial situation, so investors can make decisions about whether the company is able to meet its short-term needs. Liquidity ratios are important for creditors and investors, because a company must have adequate liquidity to avoid defaulting on its debts.
Definition
Liquidity ratios measure the short-term solvency of a business. They are calculated by comparing a company’s current assets to its current liabilities to determine how well the firm can meet its obligations as they come due. A high liquidity ratio indicates that the company has more liquidity than it needs, while a low ratio suggests that the company may have difficulty meeting upcoming payments.
Examples
The most commonly used ratios are the current ratio, quick ratio, and the cash ratio. The current ratio is calculated by dividing current assets by current liabilities. The quick ratio is calculated by taking current assets minus inventories, and then dividing by current liabilities. The cash ratio is calculated by dividing cash and cash equivalents by current liabilities. These ratios can be used to assess a company’s short-term liquidity and are often compared to industry benchmarks.
- Current Ratio = Current Assets / Current Liabilities
- Quick Ratio = (Current Assets - Inventories) / Current Liabilities
- Cash Ratio = Cash and Cash Equivalents / Current Liabilities
Profitability Ratios
Profitability ratios are a set of ratios that measure an entity's ability to generate profits. These financial metrics may be useful when comparing relative levels of profitability between similar entities or when gauging how different management decisions or market conditions affect an entity's profitability.
Definition
Profitability ratios measure the overall performance of a company in terms of its ability to generate profits from its sales or investments. Profit margin ratios look at the overall profitability of a business by measuring net income as a percentage of sales or net profit as a percentage of assets. Other profitability ratios measure the efficiency of a business, such as the return on assetswhich measures how efficiently a company is using its assets to generate profits.
Examples
Some common profitability ratios include:
- Gross profit margin: measuring the net sales as a percentage of gross profit
- Net profit margin: measuring the net profit generated by a business as a percentage of net sales
- Return on assets (ROA): measures the efficiency of a company in generating profits from the use of its assets
- Return on equity (ROE): measures the amount of profit generated from a business's equity capital
- Earnings per share (EPS): measures the amount of net profit generated by a company divided by its number of outstanding shares
4. Solvency Ratios
Solvency ratios are a measure of a company's ability to pay off its long-term debt. These ratios are useful in determining a company's overall financial health and stability. It is important to note that debt to equity ratio, which shows how much of the company's assets are financed by debt, is not a solvency ratio.
A. Definition
Solvency ratios measure the ability of a company to pay off its long-term debt obligations. They are calculated by dividing the long-term debt of a company by its total assets. The result is expressed as a percentage. When this percentage is high, it means that the company has high leverage, meaning it has more debt than assets. A lower percentage shows that the company has more assets than debt.
B. Examples
The three most commonly used solvency ratios are:
- Debt to Equity Ratio (D/E) - This ratio is used to assess the amount of debt a company is carrying relative to their shareholders' equity.
- Current Ratio (C/C) - This ratio measures the company's ability to pay off its current liabilities using only its current assets.
- Interest Coverage Ratio (I/C) - This ratio measures the company's ability to cover its interest payments with its current income.
It is important to note that debt to equity ratio, which shows how much of the company's assets are financed by debt, is not a solvency ratio.
Efficiency Ratios
Efficiency ratios are a set of financial ratios used to measure the capability of a business to utilize its assets and manage its liabilities efficiently. In simpler words, efficiency ratios measure the rate of conversion of a business’s assets into sales or of its expenses into sales. These ratios are useful to understand the time frame of a business process and the expenses associated with such process.
Definition
Efficiency ratio is a ratio which measures the ability of a company to turn its assets into sales or to manage its liabilities and investments efficiently. Efficiency ratios are useful to assess the time frame of a business process and the expenses associated with such process.
Examples
Some common examples of efficiency ratios are Inventory Turnover Ratio, Asset Turnover Ratio, Accounts Receivable Turnover Ratio and Accounts Payable Turnover Ratio.
- Inventory Turnover Ratio: This ratio measures the number of times a company has sold and replaced its inventory within the specified period.
- Asset Turnover Ratio: This ratio determines how well a company utilizes its assets to manufacture products and turn them into sales. It is calculated by dividing the net sales by the average total assets of the period.
- Accounts Receivable Turnover Ratio: This ratio measures the speed at which a company is able to collect its receivables from customers. It is computed by dividing the total number of accounts receivables during the period by the sum of all accounts receivable aging from the oldest to the newest.
- Accounts Payable Turnover Ratio: This ratio measures the speed at which a company pays its suppliers. It is computed by dividing the total number of accounts payables during the period by the sum of all accounts payable aging from the oldest to the newest.
Investment Value Ratios
Investment value ratios measure the value of an investment relative to its book value, cost, or its market value. This type of ratio helps investors decide whether an investment is a good value or not. Knowing the value of an investment can help investors decide whether to buy or sell the investment.
Definition
Investment value ratios are financial ratios use to determine the price of a stock or bond in comparison to its actual or perceived value. They measure the ratio of the market value of an investment relative to its book value, cost, or potential. Investment values can help investors decide whether to purchase or sell the security.
Examples
The various examples of investment value ratios are as follows:
- Price to Sales Ratio (P/S Ratio) – measures the value of a company by comparing its stock price to its total revenue
- Price to Earnings Ratio (P/E Ratio) – measures the value of a company by comparing its stock price to its earnings per share (EPS)
- Price to Book Ratio (P/B Ratio) – measures the value of a company by comparing its stock price to its book value per share.
- Price to Cash Flow Ratio (P/CF Ratio) – measures the value of a company by comparing its stock price to its cash flow per share
- Dividend Yield Ratio – measures the amount of income an investor can receive from dividends on a stock relative to the price of that stock
- Enterprise Value to Sales Ratio (EV/S Ratio) – measures the value of a company by comparing its enterprise value to its total revenue
Conclusion
This blog post has examined the various kinds of financial ratios that can be utilized to measure a business’s performance. The ratios included liquidity ratios, profitability ratios, debt ratios, and activity ratios. By using these ratios, businesses can measure their progress and performance against industry averages or their competitors.
Summary of information discussed
Liquidity ratios measure how quickly assets can be converted into cash. Examples include the current ratio and the acid-test ratio. Profitability ratios measure the efficiency and effectiveness of management in generating profit. Examples include the return on assets ratio, the return on equity ratio, and the income ratio. The debt ratio measures the presence of debt in the company’s financing structure. Examples include the total debt to total assets ratio, the short-term debt to total capital ratio, and the equity multiplier ratio. Activity ratios measure the asset utilization of a business. Examples include the inventory turnover ratio, the accounts receivable turnover ratio, and the fixed asset turnover ratio.
Final points on importance of understanding financial ratios
These ratios allow businesses to understand the financial standing of their company, benchmark against competitors and industry averages, and identify areas of improvement. They also allow businesses to assess the leverage of their company and determine its ability to pay back loans. Finally, understanding these ratios can help businesses forecast their future financial stability and plan ahead.
Overall, financial ratios are essential tools for monitoring business performance and assessing financial risk. With a thorough understanding of each of the different types of financial ratios, businesses can make more informed decisions about their operations and the direction of their business.